PowerShares set to list bond ETF on NYSE

Invesco PowerShares is planning to list a fundamentally-weighted corporate bond ETF on the New York Stock Exchange on Thursday.

The ETF will track the Research Affiliates Fundamental Index (RAFI) methodology which selects bonds based on cash flow, dividends, sales and book value of assets. Maturities of the bonds range from one to 10 years.

Traditional fixed income indices tend to select their components based on the size of issuance, which therefore exposes investors in the index to the most heavily indebted companies. This has been a criticism of fixed income ETFs.

"We think that the concept of fundamentally weighting products as opposed to cap-weighting, particularly in the case of fixed income ETFs, is a more common sense weighting methodology," says Ed McRedmond, senior vice president of institutional and portfolio strategies at PowerShares in Wheaton, Illinois.

"If you are weighting based on a company's fundamentals and two of those factors are cash flow and dividends, logic would tell you that those factors might be indicative of a company's ability to service debt."

Market cap-weighted indices can also be difficult to replicate under the physical replication methodology, which PowerShares (like most US providers) uses for its ETFs.

"In the traditional fixed income indexes, there may be bonds in the index which haven't traded for years so for ETFs to closely track that index is a big challenge," says McRedmond.

"The fundamental-weighted bond index is designed to be constructed from a much more investable universe."

There is a smaller universe of issues in the RAFI Investment Grade Corporate Bond Index compared to some traditional fixed income indices, which also makes replication easier, he adds.

The PowerShares Fundamental Investment Grade Corporate Bond Portfolio is the second fixed income ETF from the provider which uses the RAFI methodology. In August last year, it switched the underlying for its high yield ETF to the RAFI High Yield Bond Index.

Since the change was made assets in the ETF have increased from approximately US$200mn to $519mn at the close of business in the US on 12 September.

The ETF provider also uses the RAFI methodology for several of its equity ETFs and McRedmond says there are likely to be fundamentally-weighted offerings in future.

"We are a big believer in the fundamental-weighted methodology... To the extent that Research Affiliates develop indexes our product development teams will be interested in looking at them and I can't think of any reasons why that wouldn't expand over time."